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New regulation and the new world of global banking.

Global banks are changing. With a new set of rules come new business models. We review the international dimension of the financial crisis, centring on cross-border losses and cross-currency funding problems that prompted authorities to adopt wide-ranging rescue measures and liquidity operations. Against this background, we proceed to examine the regulatory response, focusing on the Basel Ill framework and the ongoing work of the Basel Committee and Financial Stability Board regarding the amount of capital banks are required to hold. restrictions on maturity transformation on banks' balance sheets and proposals to mitigate the risks posed by systemically important financial institutions. Our conclusion is that capital and liquidity regulation will have distinctly different effects on the international organisation Noun 1. international organisation - an international alliance involving many different countries
global organization, international organization, world organisation, world organization
 of banks. Liquidity regulation, especially when applied locally, has the greatest potential to reshape the global banking landscape.

Keywords: Global banks: financial crisis: multinational banking; local operations: regulatory reform Regulatory Reform concerns improvements to the quality of government regulation.

At the international level, the "OECD Regulatory Reform Programme is aimed at helping governments improve regulatory quality -- that is, reforming regulations that raise unnecessary obstacles to
: Basel III: capital regulation; liquidity regulation.

JEL Classifications: F36; G01; G21; G28; H12

I. Introduction

Internationally active banks were at the centre of the global financial crisis. Massive credit losses, often on foreign asset holdings, in combination with dislocations in international wholesale funding markets, resulted in actual and near failures of large globally active banks. At the height of the crisis in the final months of 2008, doubts about the solvency of global banks contributed importantly to the evaporation evaporation, change of a liquid into vapor at any temperature below its boiling point. For example, water, when placed in a shallow open container exposed to air, gradually disappears, evaporating at a rate that depends on the amount of surface exposed, the humidity  of liquidity in interbank lending markets, as well as in markets for repurchase agreements and securitised assets in nearly all major currencies. As a direct consequence of these difficulties, a substantial part of public support, including funds for recapitalisation and massive amounts of central bank liquidity in domestic and foreign currency, ended up being channelled to global banks.

The crisis exposed three major weaknesses in the way large global banks conducted their business. First, their capital cushions were too slim and of insufficient quality to absorb losses, much less to reassure market participants of their soundness. Second, they had taken on too much maturity transformation, so liquidity buffers were too small and liquidity management inadequate to withstand the stress when key funding markets worldwide became illiquid Illiquid

An asset or security that cannot be converted into cash very quickly (or near prevailing market prices).

Notes:
A house is a good example of an illiquid asset.
See also: Cash, Liquidity



Illiquid

In the context of finance.
. And third, the global financial system, particularly with its reliance on over-the-counter transactions, had become highly interconnected so that downward pressure on asset prices precipitated by forced asset sales at one institution would have immediate and considerable knock-on effects, depressing prices and collateral values in a wide array of markets. The bigger the bank and the further its global reach, the worse the externalities externalities

side-effects, either harmful or beneficial, borne by those not directly involved in the production of a commodity.
 it creates.

Against this backdrop, the regulatory response has naturally focused on capital, liquidity and the externalities created by large global banks. Key elements of the regulatory reform took shape in the course of 2010. Most importantly Adv. 1. most importantly - above and beyond all other consideration; "above all, you must be independent"
above all, most especially
, the Basel III capital framework was endorsed by the G20 leaders at the Seoul summit in November 2010, and was finalised in December 2010. Furthermore, at the time of writing, the Basel Committee and the Financial Stability Board are continuing their work on requirements designed to mitigate risks posed by systemically important financial institutions (SIFIs).

The key objective of new regulatory frameworks is both to make individual banks safer and to contain the buildup of systemic risk Systemic Risk

Risk common to a particular sector or country. Often refers to a risk resulting from a particular "system" that is in place, such as the regulator framework for monitoring of financial_institutions.
. This means more capital, more liquidity and better risk management. That is, less leverage, less maturity transformation and internalisation Noun 1. internalisation - learning (of values or attitudes etc.) that is incorporated within yourself
internalization, incorporation

learning, acquisition - the cognitive process of acquiring skill or knowledge; "the child's acquisition of language"
 of the pernicious externalities that propelled the crisis. In other words Adv. 1. in other words - otherwise stated; "in other words, we are broke"
put differently
, new regulations are designed to force changes in business models and incentives for global banks and those who run them. These are intended, not unintended, consequences.

It is worth noting that market forces have worked in the same direction as the new regulation, requiring banks to hold more capital and strengthen liquidity buffers. From this perspective, the new regulation is supporting and institutionalising an adjustment process towards a sounder banking industry, reinforcing the improvements in balance sheets and risk management and ensuring that they will not be reversed as the next boom unfolds.

In the remainder of this article we discuss how the regulatory response to the crisis is affecting the way global banks go about their business. "Faking an international perspective, we begin with a summary of the weaknesses exposed by the crisis. Then, in section 3, we turn to the regulatory response and, in section 4, to the implications for the organisation of global banking. Section 5 concludes.

2. The global dimension of the financial crisis

The years before the crisis saw a remarkable expansion of global banking. The outstanding stock of banks' foreign claims (1) outpaced both the growth of international trade and broader economic activity, growing from $10 trillion in early 2000 to $34 trillion by end-2007. As banks' global balance sheets grew, so did their appetite for foreign currency assets, especially US dollar-denominated claims on non-bank entities. Not only did banks boost loans to retail and corporate borrowers, as well as financial entities such as hedge funds, but they also had an apparently insatiable appetite for structured finance products, predominantly those based on US mortgages. (2) Until late into 2007, foreign private net purchases of US securities were running at a volume close to the then very high US current account deficit (Bertaut and Pounder, 2009). By September 2008, BIS reporting banks had amassed $6.3 trillion in US dollar claims on US borrowers, 89 per cent of ,which was on private sector entities.

Comparing individual banking systems, (3) we see that the growth in the global positions of European banks stands out. Foreign claims expanded rapidly and, for some banking systems, have come to exceed the GDP GDP (guanosine diphosphate): see guanine.  of their respective home countries, sometimes by large multiples. Looking at the left-hand panel of figure 1, we note that Swiss banks' foreign claims peaked at close to ten times Swiss GDP. In comparison, the same figure shows that the scale of foreign claims booked by Japanese and US banks was more moderate.

With the benefit of hindsight, we now see that this rapid pre-crisis expansion of global banks' balance sheets was associated with a major build-up of vulnerabilities. First there was the size itself. Bank assets and leverage were increased substantially. Between 2003 and 2007, total assets of 23 of the largest global banks rose from $15 to $35 trillion, driving up their leverage--calculated as the ratio of total assets to total equity--from 22 to 27 (weighted average). In some important cases the increase was much larger, with leverage ratios rising to over 50. (4)

Next, there was the funding. As balance sheets expanded, international banks incurred large maturity and currency mismatches. On the maturity side, banks were borrowing in short-term wholesale markets to finance the purchase of long-term assets. The associated large-scale maturity transformation exposed banks to considerable funding liquidity risk (BIS, 2009) and, on the currency side, expansion into foreign currency assets meant they became reliant on cross-currency funding and FX swap markets (McGuire and yon Peter, 2009). European and Japanese banks funded their holdings of US dollar assets essentially in two ways. One was to borrow dollars on the global interbank market and :from non-bank sources, relying substantially on short-term wholesale funding; the other was to convert domestic currency, drawn in part from their home deposit base, into dollars by means of FX swap contracts. Banks whose foreign currency asset holdings persistently exceeded their funding in the same currency had thereby built up structural cross-currency funding needs, and their use of FX swaps to eliminate currency risk gave rise to rollover A graphic element in an application or on a Web page that changes its color or shape when the pointer is moved (rolled) over it. See JavaScript rollover. See also n-key rollover.  risk on account of the short average maturities of swap contracts. (5)

[FIGURE 1 OMITTED]

The US dollar funding needs among European banks had become particularly large. While an exact figure is difficult to calculate from available information, even lower-bound estimates show that their structural dollar funding needs had risen to "well in excess of $1 trillion for mid-2007 (figure 1, right-hand panel). (6) The dollar funding gap measures the amount of dollar liabilities that banks must roll over before their investments mature or can be sold.

The combined currency and maturity transformation implicit in Adj. 1. implicit in - in the nature of something though not readily apparent; "shortcomings inherent in our approach"; "an underlying meaning"
underlying, inherent
 these funding gaps--financing long maturity dollar assets with short-term dollar borrowing or local currency borrowing plus a swap--became unsustainable as the various sources of dollar funding dried up one by one beginning in mid-2007. Uncertainty about the soundness of major banks gave rise to a reduction in counterparty limits, a progressive shortening of funding maturities, and precautionary hoarding of liquidity (CGFS CGFS Committee on the Global Financial System
CGFS Child Guidance & Family Solutions
CGFS curriculum guidance for the foundation stage
CGFS Canadian Goldfish Society
, 2010a). Interbank and other unsecured markets seized up first, leading to dislocations in repo Repo

An agreement in which one party sells a security to another party and agrees to repurchase it on a specified date for a specified price. See: Repurchase agreement.


repo

See repurchase agreement (RP).
 and FX swap markets. The widening of Libor and FX swap spreads shown in figure 2 reflected the rise of both credit and liquidity premia (Michaud and Upper, 2008). Funding pressures spilled over to secured markets as liquidity providers withdrew and repo market activity became increasingly concentrated in the shortest maturities and the highest-quality collateral (Hordahl and King, 2008; Gorton, 2009; Gorton and Metrick, 2011).

Further compounding the pressure on European banks was the instability in non-bank dollar funding sources. In the aftermath of the bankruptcy of Lehman Brothers Lehman Brothers Holdings Inc. (NYSE: LEH), founded in 1850, is a diversified, global financial services firm. It is a participant in investment banking, equity and fixed income sales, research and trading, investment management, private equity, and private banking.  in September 2008, money market funds facing large redemptions withdrew from bank-issued paper (Baba et al., 2009). At the same time, many dollar assets on banks' balance sheets became difficult to sell into illiquid markets without realising major losses. In essence, the effective holding period of assets got longer just as the maturity of available funding got shorter. This endogenous rise in maturity mismatch precipitated the US dollar shortage.

The deepening of the crisis following the Lehman failure brought the size of externalities created by the activities of large global banks into clear focus. All banks, regardless of size or any objective measure of creditworthiness Creditworthiness

The condition in which the risk of default on a debt obligation by that entity is deemed low.


Creditworthiness

Eligibility of an individual or firm to borrow money.
, were suddenly unable to roll over short-term debt. Large increases in margin and haircuts meant huge margin calls that forced asset sales resulting in larger losses, more funding difficulties and further margin calls (CGFS, 2009). Liquidity spirals hurt everyone (Brunnermeier, 2009). The interconnectedness of large financial institutions through interbank funding and derivatives markets made it impossible to identify and isolate non-viable institutions. When Lehman failed, everyone became suspect.

[FIGURE 2 OMITTED]

With the entire financial system teetering on the edge of the abyss, the official response was unprecedented in both its size and scope. Bank balance sheets were strengthened through a combination of recapitalisations, asset purchases and insurance schemes; the scope and ceilings of deposit insurance were raised, and non-deposit liabilities were guaranteed in an effort to prevent wholesale runs; and central banks This is a list of central banks.

Contents A B C D E F G H I J K L M N O P Q R S T U V W Y Z
 created a number of programmes aimed at providing liquidity and improving the functioning of key markets (BIS, 2009). The overall amount of resources committed to the various packages totalled around $6 trillion, or almost 20 per cent of the GDP of major advanced economies (Panetta et al., 2009). (7)

The mere fact that banks needed large-scale recapitalisations emphasises that the pre-crisis levels of capital were too low. Throughout the crisis, banks took staggering credit losses (figure 3, left-hand panel), if capital levels had been sufficient, there would have been no need for officials to "worry about whether banks would remain healthy enough to be able to continue to play their essential role of intermediating credit. In the quarter following the Lehman bankruptcy alone, the public sector injected over $250 billion of capital into global banks (figure 3, right-hand panel). (8) But, as can be seen from the fact that a number of institutions fall below the 450 line in the left-hand panel, even this massive effort fell short of matching losses in a large number of cases. Accordingly, aggregate losses ($1,980 billion) outpaced total private plus public recapitalisations ($1,607 billion) for the banks, brokers and insurers quoted on Bloomberg.

As we have already mentioned, solvency and liquidity were not the only problems faced by global banks. They needed liquidity well beyond their home currency, namely in US dollars, and lots of it. To address this extraordinary predicament, central banks created a network of bilateral swap lines. The result was that foreign central banks could obtain US dollars from the Federal Reserve, which they in turn could auction off to the banks in their jurisdictions. The first swap lines were established in December 2007. Over the following year, their number multiplied and limits were gradually raised until they became unlimited in four important cases (the ECB See electronic code book. , the Bank of Japan, the Swiss National Bank The Swiss National Bank is a central bank, responsible for the monetary policy of Switzerland and issuing the Swiss franc banknotes.

The names of the institution in the four official languages of the country are: German:
 and the Bank of England Bank of England, central bank and note-issuing institution of Great Britain. Popularly known as the Old Lady of Threadneedle Street, its main office stands on the street of that name in London. ). At the peak in December 2008, the international provision of US dollars reached $583 billion. This mechanism was highly effective in addressing the cross-border funding stresses that had materialised so quickly and unexpectedly (CGFS, 2010a).

[FIGURE 3 OMITTED]

3. The international regulatory response

The crisis revealed three key areas in which international regulatory action was required. Banks needed (1) to hold more capital, (2) to hold more liquidity, and (3) to be forced to face the externalities that their actions create for the system as a whole. Officials have been hard at work fashioning international standards designed to meet all of these objectives. The effort has adopted a two-pronged approach; on the one (microprudential) hand, new regulations aim at strengthening the resilience of individual banks by raising the level and quality of bank capital and by establishing a global liquidity standard. On the other (macroprudential) hand, the goal is to resist the build-up of systemic risk by adding a leverage ratio and countercyclical buffers and limiting the risks emanating from SIFIs, as well as to reduce the degree of uncertainty and interconnectedness by having OTC OTC

See: Over-the-counter.


OTC

See over-the-counter market (OTC).
 derivatives traded on exchanges and cleared through central counterparties.

Starting with bank capital, the new framework raises both the required level and quality of capital. To understand the changes and their importance, consider that a risk-based capital requirement Risk-Based Capital Requirement

A stated requirement of liquid reserves placed upon banks and institutions that deal in risky ventures.

Notes:
These requirements exist for the protection of investors who hold an interest in these types of businesses.
 is quoted as a ratio with three elements: the numerator numerator

the upper part of a fraction.


numerator relationship
see additive genetic relationship.


numerator Epidemiology The upper part of a fraction
 (how you measure capital), the denominator (how you measure the assets against which loss-absorbing capital must be held) and the ratio itself. The new framework agreed by the Governors and Heads of Supervision of the 27 Basel Committee member countries strengthened all three of these.

First, regarding the numerator, the Basel Committee's efforts to strengthen the capital base have focused on common equity, the most loss-absorbing form of capital. The result is a much stricter definition of what counts as Tier 1 capital Tier 1 Capital

A term used to describe the capital adequacy of a bank. Tier I capital is core capital, this includes equity capital and disclosed reserves.

Notes:
Equity capital includes instruments that can't be redeemed at the option of the holder.
 accompanied by more stringent regulatory adjustments (ie, deductions):from capital. Second, regarding the denominator, the Committee has taken a series of measures to ensure that the regulatory capital framework covers the full range of significant risks. Adequate capital can only protect against unexpected losses provided all risks are comprehensively covered. And third, looking at the capital adequacy ratio Capital adequacy ratio (CAR), also called Capital to Risk (Weighted) Assets Ratio (CRAR)[], is a ratio of a bank's capital to its risk. National regulators track a bank's CAR to ensure that it can absorb a reasonable amount of loss.  itself, a key component of Basel III is the significant increase of the minimum common equity requirement to 4.5 per cent. This compares with the pre-crisis minimum requirement of 2 per cent. But because of the changes in the definition mentioned above, this simple comparison understates the degree to which banks will have to increase their capital. Shifting from the old, lenient definition of capital to the new, stricter one cuts the existing amount of capital eligible to meet the requirements in half. That is, given the current composition of assets that many global banks are holding, the previous minimum would be closer to 1 per cent. So, the additional capital banks will be required to accumulate is much greater than a casual glance would make it appear.

But this substantial strengthening of the regulatory minimum--the level below which regulatory intervention (including closure) would be statutorily required--is only the first step. The crisis demonstrated the importance of building capital buffers during good times in order to create a cushion that can be drawn down in times of stress. "Faking this lesson to heart, the Basel Committee embraced the creation of a capital conservation buffer, set the level at 2.5 per cent and required that it be made up of common equity. Adding this to the 4.5 per cent figure for the minimum requirement gives a 7 per cent overall ratio (figure 4).

The Committee has also endorsed the creation of a countercyclical buffer that will increase capitalisation by up to an additional 2.5 percentage points during periods of excess credit growth. (9) Financial risks typically mount during times of very rapid credit expansion; investor exuberance drives up asset prices, collateral values rise, and banks relax lending standards because they want to get their share of what is seen as an ever growing cake. Raising the fences during such periods helps to achieve the broader macroprudential goal of protecting the banking sector from periods of excess credit growth. In addition, a new leverage ratio is introduced to complement the risk-based regime and to contain the build-up of system-wide risk.

Next is liquidity. As mentioned earlier, maturity mismatches were at the core of the crisis. That said, we have to acknowledge that maturity transformation is one of the things we rely on the banking system to do. There may never be enough short-term liabilities issued by governments and the private sector to satisfy the natural need for liquid short-term savings instruments by individuals and corporations, so we should not begrudge be·grudge  
tr.v. be·grudged, be·grudg·ing, be·grudg·es
1. To envy the possession or enjoyment of: She begrudged him his youth. See Synonyms at envy.

2.
 batiks their primary function of providing these vehicles to the public, and remunerating them with the returns they can earn on longer-term assets. But, at the same time, we can make sure that banks hold more liquid assets Cash, or property immediately convertible to cash, such as Securities, notes, life insurance policies with cash surrender values, U.S. savings bonds, or an account receivable.  and manage their liquidity risks appropriately. This is the objective of the Basel Committee's new liquidity standard.

Briefly, the liquidity coverage ratio (LCR See least cost routing. ) forces banks to hold liquid assets against potentially unstable liabilities. It requires that the ratio of the stock of high-quality liquid assets to cumulative expected net cash outflows over a 30-day period equals or exceeds unity continuously. Tiffs seeks to ensure that a bank maintains an adequate level of unencumbered, high-quality assets that can be converted into cash to meet liquidity needs in a short-term liquidity stress scenario. (10)

The net stable funding ratio Funding ratio

The ratio of a pension plan's assets to its liabilities.
 (NSFR) requires that banks seek stable liabilities against illiquid assets. The NSFR seeks to limit banks' reliance on short-term wholesale funding by controlling maturity mismatches over the medium and longer term. Specifically, it requires that the available stable funding (capital, long-term liabilities and a share of stable deposits) equals or exceeds the required stable funding in a stress scenario, calculated as a weighted sum across asset classes held by the institution. This ratio is meant to limit a bank's aggregate maturity mismatch, covering most aspects of the balance sheet over the medium and longer term as well as off-balance sheet items. The intention is to create incentives for banks to fund their activities with more stable sources of funding on an ongoing structural basis.

The two requirements address different sources of liquidity problems. The LCR aims to protect a bank against the inability to meet its short-term payment obligations because many assets cannot be liquidated under adverse market conditions. The longer-term NSFR limits maturity transformation. Both requirements are complementary as funding problems and illiquid markets typically coincide in a crisis.

We should note that establishing a liquidity requirement means treading in an area where economic theory provides virtually no guidance. In contrast to capital regulation, there have been no internationally harmonised Adj. 1. harmonised - involving or characterized by harmony
consonant, harmonical, harmonized, harmonic

harmonious - musically pleasing
 liquidity standards to date. In doing what amounts to placing a tax on maturity and liquidity transformation, we would like to know what the optimal level of maturity transformation should be in an economy. Alas, we do not. (11)

[FIGURE 4 OMITTED]

Before moving on, it is important to note that implementation of the new capital and liquidity requirements extends over years. As shown in figure 4, capital requirements Capital requirements

Financing required for the operation of a business, composed of long-term and working capital plus fixed assets.
 will be phased in. gradually, and the liquidity standards will go through a parallel observation period designed to identify and address any unintended consequences. As the two ratios surely alter the behaviour of banks, they could induce changes in market functioning, liquidity provision, yield curves and central bank operations. It is possible that the different regulatory treatment of instruments and maturities will cause some degree of market segmentation Market Segmentation

A marketing term referring to the aggregating of prospective buyers into groups (segments) that have common needs and will respond similarly to a marketing action.
 that will widen the spread between liquid and less liquid instruments, and steepen the yield curve between short and longer maturities.

This brings us to systemic risk, and the externalities arising from the existence of SIFIs. Reforms need to confront two complementary problems. First, unlike the case of a small bank, authorities lack appropriate resolution powers to handle the failure of a systemically important non-bank or cross-border banking group (Brierley, 2009; Goodhart and Schoenmaker, 2009; BCBS BCBS Blue Cross/Blue Shield
BCBS Basel Committee on Banking Supervision
BCBS Barre Center for Buddhist Studies
BCBS Bay City Baptist School
BCBS Bishop Cotton Boys School (Bangalore, India)
BCBS Bar Code Business Software
, 2010a). Even today, because of their size, complexity and systemic interconnectedness, disorderly failure would pose a significant risk to the wider financial system and the economy at large (FSB (FrontSide Bus) See system bus.

FSB - front side bus
, 2010). But, as if that were not a big enough challenge, officials also need to face the fact that if a SIFI SIFI Science Fiction (less common than SciFi)
SIFI Seismic Induced Frame Instability
 begins to experience stress--even if not imminently life-threatening--this will affect other institutions, possibly many other institutions. Their size and central position in multiple markets make them essential counterparties already as a going concern. Once they endure financial distress Financial distress

Events preceding and including bankruptcy, such as violation of loan contracts.
, reputational contagion Contagion

The likelihood of significant economic changes in one country spreading to other countries. This can refer to either economic booms or economic crises.

Notes:
An infamous example is the "Asian Contagion" that occurred in 1997 and started in Thailand.
 and distress selling quickly impair market-making and asset valuations with consequences far beyond the group of immediate counterparties. And in the event of a failure, the countless interlinkages a SIFI maintains through OTC and other markets can instantly cast a shadow on virtually all other institutions, and give rise to so much uncertainty and risk aversion risk aversion

The tendency of investors to avoid risky investments. Thus, if two investments offer the same expected yield but have different risk characteristics, investors will choose the one with the lowest variability in returns.
 that markets come to a standstill.

As it currently stands, if a SIFI starts to experience problems, authorities are faced with the unpalatable choice between risking catastrophe or providing a public bail-out. It is worth stating clearly that having done this once already, in some jurisdictions, another bail-out is not an option.

So, meeting the challenge posed by SIFIs requires both reducing their likelihood of coming under stress on the one hand, and improving their resolvability in the event of a failure on the other. The solution is in two parts: improving their ability to absorb losses when they inevitably occur, and creating a credible resolution regime. A variety of solutions to the first of these has been suggested. Financial firms could be required to hold additional capital based on a measure of their systemic importance. While this might come in the form of a higher minimum for common equity, it could also come in other forms. Suggestions include various forms of bonds that either convert to capital or are required to share in an institution's losses. In any case, what amounts to capital surcharges help to force SIFIs to internalise v. 1. (Psychology) Same as internalize.

Verb 1. internalise - incorporate within oneself; make subjective or personal; "internalize a belief"
interiorise, interiorize, internalize
 the externalities that they create.

With regard to resolution, improved regimes need to be developed so that the vital parts of an impaired bank can keep functioning while other business lines can be unwound un·wound  
v.
Past tense and past participle of unwind.

unwound unwind
 in an orderly manner. It takes credible regimes to address the moral hazard Moral Hazard

The risk that a party to a transaction has not entered into the contract in good faith, has provided misleading information about its assets, liabilities or credit capacity, or has an incentive to take unusual risks in a desperate attempt to earn a profit before the
 created by SIFIs, and the public sector intervention to support them, in the aftermath of the Lehman failure. While a global insolvency/bankruptcy regime would contribute to an orderly winding down of a failed global firm, such a regime is not foreseen in the near future. The cross-border context raises a host of legal and supervisory issues. Until such global arrangements are available, the Basel Committee has set out recommendations that would help mitigate the effects of cross-border failures (BCBS, 2010a). Going forward, the prospect of orderly failure also holds the promise of ending certain competitive distortions and moral hazard associated with SIFIs.

In conclusion, the new regulatory landscape has three essential components: strong capital requirements, harmonised and uniform liquidity requirements, and a combination of greater loss absorbency ab·sor·bent  
adj.
Capable of absorbing: absorbent cotton.

n.
A substance that is capable of absorbing.



ab·sor
 and a credible resolution regime for systemically important financial institutions. On this last point, it is worth emphasising that the two elements directed at SIFIs are complements rather than substitutions. The ability to fail in an orderly fashion is essential. But, resolution regimes cannot prevent the build-up of vulnerabilities resulting from failures in risk management and assessment. Instead, added capacity to absorb losses, through capital surcharges and the like, provide an additional buffer to minimise the risk that a SIFI under stress will bring the system down.

4. Prospects for the shape of global banking

Stronger capital requirements can be expected to bring substantial benefits at only a modest cost. One study concludes that bringing the global common equity capital ratio to a level in line with the agreed minimum and the capital conservation buffer would result in a maximum decline in GDP relative to the baseline forecast of a cumulative 0.22 per cent of GDP over eight years (MAG, 2010). At the same time, the long-term benefits of lowering the probability of banking crises (and therefore output losses) far outweigh the long-term costs in terms of lending spreads tinder a wide range of assumptions (BCBS, 2010c).

The effects of macroprudential policies are harder to assess. Case studies suggest that the financial system would probably have been more resilient had such capital conservation measures and countercyclical buffers been in place before the crisis. A counterfactual scenario, in which national authorities would have applied macroprudential policies in the boom years before 2008, is less severe than that which played out during the actual crisis, because capitalisation, on top of a higher minimum requirement, would have been boosted by 5 per cent through the combined effect of the capital conservation and countercyclical buffers (Caruana, 2010).

Beyond its impact on the feedback between the financial sector and the real economy, the new regulatory framework will also affect the way international banks organise their activities. In this, however, we need to distinguish the potential impact of the new capital and liquidity frameworks. The capital framework adopts a consolidated perspective, with responsibility for supervision remaining largely with the home country regulator. Many aspects of international organisation, such as intragroup funding and contingency lines, are therefore netted out of the consolidated picture. As such, the strengthening of capital requirements is, in our view, unlikely to change significantly the way banks organise their global business, other than by moderating expectations on balance sheet growth and return on equity.

Liquidity regulation is a different story. It could change the face of global banking. The main reason is that liquidity is intrinsically more local in nature than capital. For liquid assets to be judged adequate and immediately available, they need to have a local component. That is, they need to be held locally (and possibly also eligible as collateral at the central bank in that jurisdiction). Moreover, the Basel Committee regards foreign exchange risk as a source of liquidity risk and recommends that the LCR be assessed in each significant currency. When implemented, this requirement will tie liquid assets closely to local funding in the host country currency. In other words, a UK subsidiary of a Euro Area headquartered bank would have to hold pound sterling liquidity in the UK to back pound liabilities.

Correspondingly, liquidity supervision is typically a host country responsibility (BCBS, 2008). The global liquidity standard may be applied on a local basis, in contrast to the capital framework which will only be applied on a consolidated basis. (12) Indeed, a number of regulators plan for local implementation of liquidity requirements. (13) A local (or even entity-level) implementation would move the regulatory focus on host jurisdictions, a development that is likely to be further reinforced by mechanisms that improve the resolvability of SIFIs. Not only will local liabilities have to be backed by more local assets, the legal apparatus needed to implement resolution frameworks will rely, in any case, on national laws. This is among the considerations that have added weight to proposals that foreign bank offices in host jurisdictions be incorporated as standalone subsidiaries, rather than branches.

[FIGURE 5 OMITTED]

When combined, these developments can affect banks in different ways, depending on how they are currently organised and funded. Some banks follow what we would label the international model, focusing on cross-border activity out of the home country, while others follow the multinational model, operating sizeable foreign branches and subsidiaries in multiple jurisdictions. The multinational model, in turn, may be run in a centralised or decentralised Adj. 1. decentralised - withdrawn from a center or place of concentration; especially having power or function dispersed from a central to local authorities; "a decentralized school administration"
decentralized
 fashion. While a centralised bank pools funds at major offices and redistributes them around the banking group, a decentralised bank lets affiliates raise funds autonomously to finance assets in each location (CGFS, 2010b).

These different funding models can be captured in aggregate form by using the BIS international banking statistics. The left-hand panel of figure 5 examines banks' funding patterns, showing where banking systems raise the funds to support their foreign claims. Banks funding primarily at home appear on the left side of the panel, and those funding predominantly abroad on the right. Either way, funds can be sourced from residents (local) or from non-residents (cross-border). A broad range of funding models can be discerned even in these aggregate statistics. (14) For instance, Japanese and, to a lesser extent, French and German banks stand out in that they fund most of their foreign activity from their home offices--indeed, two-thirds of Japanese banks' foreign claims are funded in Japan, mostly by a large domestic deposit base. At the other end of the spectrum are banking systems that raise a substantial share of their funding outside their home country, by cross-border borrowing in various financial centres, as the Swiss and US banks do, or through extensive local funding abroad, as in the case of Canadian and Spanish banks.

The decentralised funding model is associated mainly with those hanks located in the bottom right area of the right-hand panel of figure 5. The limited role of the central treasury in allocating and distributing funds is reflected in a low" share of intragroup funding (y-axis) throughout the banking group (eg, Australian, Italian, Japanese, Spanish and UK banks). A second characteristic of the decentralised model is that local assets are also largely funded locally, leading to a high degree of local intermediation (x-axis), as observed for Spanish, Italian, Australian and UK banks.

The structure of decentralised multinational banking groups appears well aligned with liquidity regulation implemented locally or on a legal entity basis. The alternative does not. The implication is that banks following a more centralised model may need to adapt their funding models (CGFS, 2010b). First, compliance with local liquidity requirements may require that they set up local treasury functions, decentralising Adj. 1. decentralising - tending away from a central point
decentralizing

centralising, centralizing - tending to draw to a central point

centralising, centralizing - tending to draw to a central point
 the bank's liquidity management. Second, group-level maturity and currency mismatches would have to be reduced when they can no longer be netted out across worldwide offices. Since banks with a centralised funding model typically rely extensively on intragroup funding, they will :face greater adjustment. Relative to current practice, in the new regime intragroup positions would be penalised should affiliated entities be treated no differently from unrelated third-party financial institutions when liquidity standards are applied on a legal entity basis. Indeed, foreign operations in the business of fundraising or channelling intragroup funds into investments may even become unviable.

It therefore seems plausible to us that liquidity regulation, especially when applied locally, could substantially affect the geographical organisation of banking, pushing global banks towards a decentralised multinational model. Moreover, the advent of national resolution regimes, and increased moves towards forced subsidiarisation, will only accelerate this trend. It remains possible that banks, through innovative use of derivatives and contingent arrangements, could replicate the centralised model, making it just more expensive to run. But it seems more likely that the combined impact of local liquidity regulation and national resolution frameworks will continue the trend towards the multinational model (McCauley et al., 2010). We conjecture that global banking will become more local in the future.

5. Conclusions

The financial crisis had a distinctly international character, featuring cross-border losses associated with foreign country assets, cross-border funding gaps associated with :foreign currency liabilities, and cross-border contagion arising from the systemic importance of certain institutions. These phenomena point to inadequate capitalisation, insufficient liquidity, unsatisfactory resolution regimes and a failure to address the externalities created by large global banks. The regulatory reforms that are in train, both those already completed and those under development, address each of these. Ensuring that banks hold more capital, more liquidity, can be resolved in an orderly fashion and facing the effects of their actions on others will make the system more resilient and less prone to failure.

It is now essential to achieve full and timely implementation of what has already been elaborated (Basel III), and to complete the design of what has been agreed in principle (SIFI regulation and resolution frameworks), while preventing leverage and maturity transformation from being pushed outside the regulatory perimeter.

In discussing the consequences of regulatory reform, public attention has focused mostly on capital regulation. We argue, however, that global liquidity standards, especially when applied locally in conjunction with national resolution frameworks, have a much greater potential to reshape the landscape of global banking in the decades to come.

DOI (Digital Object Identifier) A method of applying a persistent name to documents, publications and other resources on the Internet rather than using a URL, which can change over time. : 10.1177/0027950111411378

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An economic condition whereby investment capital is difficult to obtain. Banks and investors become weary of lending funds to corporations thereby driving up the price of debt products for borrowers.
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The risk associated with the impact on a project's cash flow from higher funding costs or lack of availability of funds. See: interest rate risk.
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NOTES

(1) Foreign claims consist of cross-border claims and local claims booked by banks abroad, and include debt and equity instruments denominated in all currencies. The measure of foreign claims used here also includes domestic lending in foreign currency. (Adding domestic claims in domestic currency would yield total assets.)

(2) The classical drivers in earlier waves of financial globalisation included deregulation Deregulation

The reduction or elimination of government power in a particular industry, usually enacted to create more competition within the industry.

Notes:
Traditional areas that have been deregulated are the telephone and airline industries.
, growth prospects, profit margins, multinational companies, and cultural and geographical proximity (CGFS, 2010c). This latest wave took place during a period of financial innovation, the emergence of structured finance, the spread of universal banking and substantial growth in the asset management industry to which banks offer brokerage and other services.

(3) The term 'banking system' in this paper refers to the set of banks headquartered in a particular country (eg, Dutch banks. UK banks), and the analysis relates to their worldwide consolidated balance sheets.

(4) It is important to acknowledge that leverage ratios are notoriously difficult to calculate and can vary substantially depending on accounting conventions chosen (CGFS, 2009).

(5) Between 2004 and 2007, the average daily turnover of short-term foreign exchange swaps (with a maturity of up to seven days) doubled from $700 billion to $1,329 billion, reaching 78 per cent of total turnover in FX swaps.

(6) For details on the methods and limitations of these figures, see McGuire and yon Peter (2009). Limitations in netting and transferability across banks and locations would produce larger estimates of dollar funding gaps (Fender and McGuire, 2010a, b).

(7) These figures cover Australia, Canada, France, Germany, Italy, Japan, the Netherlands, Spain, Switzerland, the United Kingdom and the United States United States, officially United States of America, republic (2005 est. pop. 295,734,000), 3,539,227 sq mi (9,166,598 sq km), North America. The United States is the world's third largest country in population and the fourth largest country in area. .

(8) Governments shored up banks' Tier 1 or Tier 2 capital Tier 2 Capital

A term used to describe the capital adequacy of a bank. Tier II capital is secondary bank capital that includes items such as undisclosed reserves, general loss reserves, subordinated term debt, and more.

Notes:
This is related to Tier 1 Capital.
 by injecting resources in the form of common shares, preferred shares Preferred shares

Preferred shares give investors a fixed dividend from the company's earnings and entitle them to be paid before common shareholders. See: Preferred stock.
, warrants, subordinated debt Subordinated Debt

A loan (or security) that ranks below other loans (or securities) with regard to claims on assets or earnings. Also known as "junior security" or "subordinated loan".
, mandatory convertible Mandatory Convertible

A type of convertible bond that has a required conversion or redemption feature. Either on or before a contractual conversion date, the holder must convert the mandatory convertible into the underlying common stock.
 notes or silent participations. These recapitalisations strengthened banks' capacity to absorb further losses and reduced their cost of refinancing. Depending on the terms, recapitalisations could also dilute existing shareholders' earning rights and depress stock prices (Panetta et al., 2009). Indeed, the recapitalisations generally narrowed bank CDS spreads but did not help bank stock prices, suggesting that they benefited creditors at the expense of shareholders (King, 2009).

(9) Banks can draw on this buffer to absorb losses in periods of stress, but are subject to constraints on earnings distributions while the buffer is being rebuilt.

(10) High-quality liquid assets held in the stock should be unencumbered, liquid in markets during a time of stress and, ideally, central bank eligible (BCBS, 2010b).

(11) One possible approach is to start thinking about the optimal maturity structure of a nation's capital stock. Longer-lived capital may be more efficient at production, but less flexible in the face of unforeseen changes in technology and other shocks--economies with the right maturity structure for their capital stock will grow faster. Long-term projects, such as infrastructure, will be easier to realise at the financing stage when the risk of maturity transformation does not have to be borne by the entrepreneurs/investors, but can be pooled in the financial system. More maturity transformation thereby facilitates longer-lived capital accumulation Most generally, the accumulation of capital refers simply to the gathering or amassment of objects of value; the increase in wealth; or the creation of wealth. Capital can be generally defined as assets invested for profit. , but until what point does such transformation add value?

(12) The final rules text (BCBS, 2010b) remains ambiguous on the scope of application of the liquidity standard. The earlier consultative paper (BCBS, 2009) stated that "the proposed standards and monitoring tools should be applied to all internationally active banks on a consolidated basis, but may be used for other banks and on any subset of entities [...]. When applied on a legal entity basis, affiliated entities should be treated no differently than unrelated third-party financial institutions."

(13) One prominent example is the strengthening of UK liquidity standards, which require self-sufficiency and adequacy of liquid resources for UK entities, including subsidiaries and branches of foreign banks (FSA, 2009).

(14) The use of BIS international banking data has the advantage that the geographical aspects can be covered by data on the location of banking offices. The main disadvantage in this context is that the data are reported only in aggregated form, averaging the funding models across all banks headquartered in a particular country.

Stephen G. Cecchetti, * Dietrich Domanski ** and Goetz yen Peter **

* Bank for International Settlements (BIS), National Bureau of Economic Research, and Centre for Economic Policy Research This article or section needs sources or references that appear in reliable, third-party publications. Alone, primary sources and sources affiliated with the subject of this article are not sufficient for an accurate encyclopedia article. . ** BIS. E-mail: Goetz.VonPeter@bis.org. We have benefitted from discussions with a large number of our colleagues, including William Coen, Robert McCauley and Patrick McGuire Patrick "Pat" McGuire (b. September 27 1987, Bradford, England) is a professional footballer playing for Farsley Celtic.

As a local, Pat McGuire excelled through various amateur football teams, before graduating through the BCFC 'Centre of Excellence' youth football team
. Jhuvesh Sobrun provided competent assistance with the figures. The views expressed in this paper are those of the authors and not necessarily those of the BIS.
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Date:Apr 1, 2011
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